JGB futures tank on jitters before auction

By Chikako Mogi

TOKYO, June 2 (Reuters) - Japanese government bond futures plunged on Monday, pulling two- and five-year yields up to fresh 10-month highs, on hedge selling from nervous dealers worried about investor demand for a key 10-year note sale the next day.

The JGB market has not recovered from heavy selling over the past two months as investors shed government bonds built up while the global credit crisis deepened.

Some investors began buying bonds on dips after five- and 10-year yields rose to 10-month highs last week. But with many of them looking to further cut their JGB holdings to limit losses, such a rebound offered a chance to take profits, traders said.

Players were also worried about the threat of mounting inflation pressures, and kept a close eye on overseas bond yields and potential interest rate hikes, including from the Bank of Japan.

The Ministry of Finance will offer 1.9 trillion yen ($18 billion) of 10-year JGBs on Tuesday, followed by an auction of 500 billion yen in 10-year inflation-linked bonds on Thursday.

"Players are cautious before the 10-year note auction and are taking profits from late last week's recovery in the market," said Chotaro Morita, chief JGB strategist at Barclays Capital.

"With market sentiment still bearish, the supply this week will be a challenge for investors as to how much they can absorb," he said, adding that any rebound in prices will likely be related to short covering.

June 10-year futures 2JGBv1 shed as much as 0.91 point to 133.54, a 10-month low, before trimming some losses to end the morning down 0.76 point at 133.69.

The benchmark 10-year yield JP10YTN=JBTC rose 4 basis points to 1.790 percent, closing in on a 10-month peak of 1.805 percent hit late on Thursday.

Benchmark yields jumped about 20 basis points in May following a 30 basis-point surge in April -- the biggest two-month spike in yields since 2003.

The two-year yield JP2YTN=JBTC rose 2.5 basis points to a fresh 10-month high of 0.930 percent, fully reflecting expectations for a quarter-point rate rise from 0.5 percent in the months ahead as well as the possibility of another.

The plunge in futures pushed the five-year yield up 6.5 basis points to a new 10-month high of 1.390 percent JP5YTN=JBTC.

"Selling in the futures was amplified by players attempting to cut losses," said Naomi Hasegawa, senior fixed-income strategist at Mitsubishi UFJ Securities.

"The plunge was surprising as the usual duration extensions by index players were expected to prop up the market ahead of tomorrow's 10-year auction. Supply worries are stronger than expected," she said.

Life insurers have been shifting funds into super-long bonds from medium-term sectors during the recent sell-off as longer-term yields jumped.

On top of caution before the auction, the bearish JGB market may also have taken a hit by hedge funds unwinding positions, a dealer at a Japanese bank said.

Traders cited a lack of big buyers such as Japan Post Bank, which had supported the market by buying at the dips before its privatisation in October, as also weighing on sentiment.

Traders said that if oil prices kept away from record highs, this would ease inflation worries and support the bond market.

Oil prices were little changed below $128 a barrel on Monday. CLc1

Traders also said they would closely watch the Institute for Supply Management's manufacturing index for May due later in the day for clues on the health of the U.S. economy. Economists forecast a fall of 0.6 percent compared with a 1.1 percent drop in April. ($1=105.50 Yen) (Additional Reporting by Shinichi Saoshiro)